RRSPlease…
Max out your RRSPs! This is what everyone will tell you. You don’t pay any taxes on anything you put in an RRSP so you should take advantage of it as much as possible, right?
Not really.
As I’ve mentioned before, first you need to figure out how much you can afford to save, then come up with a balanced plan based on your goals, then decide on the best investments for you. RRSPs should play a part of that plan, but they should never be 100%, even if your RRSP portfolio is balanced.
(Sidebar: I find people get confused about what an RRSP account actually is. The truth is, most investments can be designated as RRSP accounts, but an RRSP isn’t a thing. You can’t put money in an RRSP. You can buy index funds, mutual funds, stocks, bonds, or put your money in a savings account, to name a few. Then you tell the company that you invested in, that you want those investments designated as RRSP investments. All that means is that they change their administration of those accounts. Now, they have to report them to the government under your SIN and name and the government will agree that you don’t have to pay income tax on that invested money, nor do you have to pay tax on any income those investments generate.)
Why shouldn’t you max out your RRSPs? Let’s look at a simplified example:
Joe makes $100,000/year and he decides to invest his maximum amount per year — $18,000 or 18%. Assume Joe makes this every year for 40 years at 6%. Joe starts at 31 and does this every year until he has to convert his RRSP to an RRIF at 71. Joe also retires this same year. Also, forget about inflation for the purpose of the example, because it’s confusing.
Joe turns 71 and has $3,000,000 in his investments designated as RRSPs. He transfers the $3,000,000 to an RRIF, as is required by the law, but his investments pretty much remain the same. The only difference between his RRSP and RRIF is that he is required by law to withdraw a minimum amount from an RRIF. The minimum amount at the age of 71 is 5.28%.
Before we continue, let’s congratulate Joe on being awesome. He saved for 40 years and has $3,000,000! Good for you Joe!
Joe decides he doesn’t need the full $100,000 he was making for 40 years, mostly because his house is paid off and his everyday expenses are a bit lower. He’s good with $60,000 a year. That’s all Joe wants. Any more money than that would end up right back in the savings. Also, making only $60,000 a year, he finally gets to pay less tax — forget you, tax man!
(Ok, this next part is hard, as I don’t want to upset Joe, after he followed the “max out your RRSP” rule for so long, so let’s just rip off the bandaid real quick…)
After the RRIF is set up Joe gets a letter from the CRA telling him that 5.28% of $3,000,000 is $158,400 and that’s how much he has to withdraw from his RRIF. And that’s how much he’s going to make this year(let’s ignore CPP and OAS please so Joe doesn’t have a heart attack), and he’s going to have to pay taxes on that.
So, this is Joe’s reward for his diligent savings:
1. He’s forced to withdraw $58,400 MORE than he was making before he retired
2.He’s forced to withdraw $98,400 MORE than he actually needs to live today
3.HIS TAXES ARE HIGHER THAN THEY WERE WHEN HE ORIGINALLY SAVED THE MONEY
This is a good time to review the purpose of RRSPs: Defer tax now, when your tax rate is high, and withdraw money later when your tax rate is low.
This didn’t happen for Joe!
What is the lesson here? A balanced portfolio of investments isn’t enough. You also need a balance of types of investment accounts. Some RRSP, some TFSA, some non-registered (because there isn’t enough room in the TFSA).
How’s this for an ideal situation: Joe does the same thing, but the investments are in regular non-registered accounts, so he has to pay tax. Guess what, Joe can afford the tax, and he has no problem paying tax on that $18,000 a year. In fact, he already paid it, as it was deducted from his paycheque.
40 years later, Joe withdraws whatever he wants from his non-registered accounts and pays no tax at all.
HIS TAX IS ZERO.
Why? Because he already paid tax on it. And over the years, he also paid tax on the growth of his investments as they were growing. Again, he could afford it then.
When can he not afford to pay taxes? When he’s retired and has no income.
Now Joe can do whatever he wants with his money and if he has too much, he can just let it grow and leave it to his kids or to charity. But he doesn’t have to take out more than he needs.
http://investwisely.ca/rrs-please/
